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Recency Bias Often Has Company

This month's article is the eighth in a series called "Managing Behavior in a Volatile Market" and Part I of a discussion on recency bias. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, just hit the cyber-market.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias:Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with recency bias. Sixty percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to recency bias (i.e., when making an investment decision, investors put extra weight on events that have occurred more recently, such as following a recent trend, rather than recalling events that occurred in prior time periods). Of that group, at least half were also subject to the following six biases:

For example, of the respondents who said they were subject to recency bias, 65% of them were also subject to a question designed to identify hindsight bias, and so on for the other five biases.

Below, I will provide commentary on the first three of these biases: hindsight, anchoring, and loss aversion. I will discuss why these biases are likely linked with recency and what you can do to counsel a client who has these biases.

Recency and Hindsight
Recency and hindsight bias certainly go together. Clients subject to hindsight bias believe that investment outcomes should be able to be predicted. Clients subject to recency bias put extra weight on events that occurred more recently, rather than events that occurred in prior time periods. Putting these two ideas together, clients may believe, falsely, that they can predict which investments will do well by relying on current trend information rather than looking at historical valuation information and/or doing diligent research. When this happens, they may disregard important considerations such as the prospects for the investment or current valuation, which may be key drivers of future investment success.

Advice: As I have noted in past articles, advisors need to encourage their clients to judge every investment idea on its current merits, not based on past experiences. It's not always easy! Investment ideas and asset classes go through cycles of attractiveness and unattractiveness. Be flexible in your thinking! And, most importantly, pay attention to valuation.

Recency and Anchoring
Recency and anchoring go hand-in-hand, too. For example, suppose that Jim reads about a stock ETF in the local daily newspaper. The article quotes the stock ETF as being attractively priced at $50 per share. When Jim decides to buy the fund, the price is now $52.50. Despite the fact that, at $52.50, it might still represent an attractive entry point, Jim could very well get anchored to the $50 price that was quoted in the daily newspaper. It is important to understand that Jim may not be doing himself a good service by simply buying a fund he reads about in the paper without doing more complete research. So in this case, Jim may indeed be negatively biased on two fronts: recency and anchoring biases. What can he do?

Advice: It should go without saying that it is critical to make sure you do thorough research on the funds you are investing in--don't just read the paper and make an investment! (Note: This piece of advice goes for all future discussions of recency bias.) Regarding anchoring, having a strong buy discipline is certainly a good idea. However, how many times have we identified a good investment idea but don't make the purchase because we are trying to get a cheaper price--only to find the investment goes up and stays up? Sometimes it's better to make the purchase of a good long-term investment, even if you have to pay a little more up-front.

Recency and Loss Aversion
Recency and loss aversion bias may not appear naturally tied, but let's dig into the details. When people are subject to loss aversion, they often don't like to admit they were wrong by taking a loss. As noted, clients subject to recency bias put extra weight on events that occurred more recently, rather than events that occurred in prior time periods. These two biases may not appear immediately connected--but they can certainly occur in tandem. For example, suppose Leon buys a stock based on a chart he saw on an investment website. Further suppose he paid $100, but it goes down to $80 after purchase. Loss aversion may lead Leon to hold this loser even if the investment has little or no chance of going back up anytime soon.

Advice: Loss aversion is an emotional response to losing money, and it is often difficult to correct. What I recommend is that advisors focus their client's attention not on the purchase price but rather the prospects of a positive result from the current price. Would you make the investment now? If the answer is yes, then holding is the right course of action. If the answer is no, the right course of action becomes clearer.

Conclusion
Hopefully you have learned something about recency and the biases connected with it. When you encounter a client with recency bias, think about the biases you have read about in this article. It might help to build a better client relationship!

In next month's article, we will review the next three biases associated with recency.